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ESTIMATING PERSONAL AND BUSINESS LIFE INSURANCE NEEDS

CHAPTER 15

INTRODUCTION

Financial planning professionals apply diversified techniques to determine the life insurance needs of a family. Life insurance planning involves essentially three principal, but often overlapping needs areas:

• Income replacement and family needs analysis

• Business insurance needs analysis

• Estate preservation and liquidity needs analysis

A comprehensive study of the client’s financial needs and concerns generally is the best way to conduct life insurance planning. The process of life insurance planning must begin and end with the objectives and goals of the client being paramount, even if such objectives and goals do not conform to what the adviser considers proper or appropriate values or concerns. This is not to suggest that the adviser does not have a responsibility to educate the client about the potential uses and abuses of insurance, issues normally considered when assessing life insurance needs, ownership issues, tax effects, and the like. However, ethics and prudence require that the insurance plan satisfy the client’s objectives; clients simply will not implement a plan, however well-conceived and however appropriate, if they are not satisfied that it meets their objectives.

INCOME REPLACEMENT AND FAMILY NEEDS ANALYSIS

Any method of determining a family’s insurance needs will be an estimate. Future circumstances will change in unexpected ways and basic assumptions about earnings, interest rates, inflation, and similar factors will never replicate actual experience. Consequently, every insurance program must be monitored and periodically updated to assure that the client’s needs are still being met.

Personal computers have made it possible to perform increasingly comprehensive and sophisticated analyses of insurance needs. The problem with this trend is that, as the analyses become more comprehensive and sophisticated, what is already an inherently confusing subject becomes even more so, often further reducing the client’s ability to

C o p y r i g h t 2 0 1 6 . T h e N a t i o n a l U n d e r w r i t e r C o m p a n y .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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understand and accept the insurance plan. There is frequently an unfortunate, but necessary, tradeoff between comprehensiveness and comprehension.

Insurance advisers basically use three approaches to estimate family life insurance needs:

• Rules of thumb

• Income replacement approach

• Needs approach

Rules of Thumb

The simplest methods to understand, and the least reliable, are various rules of thumb that planners frequently use to roughly estimate either the amount of insurance that clients need or the amount of premium clients should be spending on insurance.

One rough guide planners use to estimate the amount of insurance required is six to eight times the annual gross income. For example, based on this rough guide, a parent earning $50,000 per year should have between $300,000 and $400,000 of life insurance.

A similar rule that takes immediate cash needs at death into account is five times gross income, plus mortgage, debts, final expenses, and any other special funding need (e.g., college fund). For example, assume once again that a parent earns $50,000 per year but also that the mortgage is $60,000, other personal debts are $10,000, final expenses are expected to be $15,000, and that the parent needs $35,000 for the children’s college expenses. Using this rule, the parent would need insurance coverage of about $250,000 (5 × $50,000) plus $120,000 ($60,000 + $10,000 + $15,000 + $35,000), or $370,000 total.

Another rule is that the family should spend about 6 percent of the breadwinner’s gross income plus another 1 percent for each dependent on premiums for life insurance. Under this rule, a person with a nonworking spouse and three children should be spending about 10 percent of gross income on premiums for life insurance. In some cases, the rule may express the amount of premium as a percent, ranging from 5 to 15 percent, of after-tax take-home pay.

Clients may find such rules of thumb useful as a very rough starting point. They can give clients a broad sense of the scope of the problem in terms they can quickly understand. However, these rules are, at best, very limited. Individual needs vary widely and the rules of thumb do not take such variations into account. They do not consider the insured’s age, the dependents’ ages, or whether the family is a one- or two-income household. Stating the objective in terms of required premium outlays is even more limited, because premiums will vary greatly for the same amount of coverage depending on the insured’s age and plan of insurance.

Multiples-of-Salary Method

A somewhat more precise rule-of-thumb method is the use of multiples-of-salary charts such as presented below. This approach is actually a hybrid method combining the simpler rule-of-thumb methods with elements of the income replacement and needs analysis

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approaches discussed later. The chart is based on the assumption that the average family can live adequately and maintain its standard of living on 75 percent of the wage earner’s after-tax income and that the insured is the only breadwinner in the family. If income were to drop below 60 percent, the family’s living standard would suffer. The chart also assumes social security coverage and that insurance proceeds are invested at a net annual rate of 5 percent.1

To use :Figure 15.1

1. Find the column showing the spouse’s current age.

2. Locate the point in the column at which the client’s earnings intersect the spouse’s age (the 75 percent column is recommended).

3. Multiply the client’s salary by the appropriate factor.

If the age or earnings differ from those shown in the chart, interpolate using the nearest salaries and ages. For example, assume a client’s salary is $35,000 and the spouse is age forty. Since $35,000 is halfway between the $30,000 and $40,000 earnings rows and also halfway between the age thirty-five and age forty-five columns shown in the chart, one would find the multiplier by averaging the four factors shown in these row/column combinations ($30,000 row and age thirty-five column: 8.0; $30,000 row and age forty-five column: 8.5; $40,000 row and age thirty-five column: 8.0; $40,000 row and age forty-five column: 8.0). Therefore, the multiplier is 8.1 [(8.0 + 8.0 + 8.0 + 8.5) ÷ 4]. According to this rule, the estimated amount the family needs to meet its income requirements is $283,500 ($35,000 × 8.1).

Figure 15.1

In general, one would increase this amount to account for immediate capital or cash needs at death. Such capital needs would commonly include funds to pay funeral and other final expenses, to pay off debts, such as mortgages or personal loans, to fund special projects, such as children’s educations, and to set up an emergency reserve. For example, assuming your client had a $50,000 mortgage and estimated final expenses of $20,000, wanted $40,000 to fund the children’s educations, and felt that the equivalent of one year’s salary ($35,000) should be set aside for emergencies; the total capital needs would be $145,000. Adding the $145,000 required to fund capital needs to the $283,500 required to fund income needs would result in a total need of $428,500.

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Finally, one can determine the amount of additional insurance one needs by subtracting any insurance already in force and the value of other assets that are available for this purpose from the total calculated need. For example, assume the client already has $150,000 of group insurance provided through his or her employer and has otherwise saved $30,000. One would compute the amount of additional insurance needed by subtracting $180,000 from the estimated total need of $428,500 to derive the final result, $248,500.

The multiples-of-salary chart method still suffers from many of the limitations associated with the simple rules of thumb. It does not take account of the age of the insured, premium costs, or the number of dependents who must be protected. Although it does adjust for the spouse’s age (and implicitly, the number of years for which the surviving spouse needs support), it does not adjust for the ages of children. In addition, it is not a suitable method in the increasingly common case where both spouses work. Similar to the simpler rules of thumb, it does not take into account differences in tax rates or investment rates of return that may apply in different family situations.

However, if these limitations are kept in mind, this method can provide reasonable first approximations of the insurance need in simple situations.

The Income Replacement Approach

The human life value concept is the basis for a second approach that advisers use to estimate life insurance needs. The human life value concept has often been applied in wrongful death litigation and basically holds that the measure of the economic value of a life to those who depend on that person is the present value of the future earnings potential of that person. The income replacement approach to life insurance needs analysis is based on the premise that the fundamental objective of life insurance is to replace some or all of the earnings lost if an income-producing family member should die. In other words, the insurance coverage should equal the value of that person’s future earnings potential to the surviving family members.

Although one may question the basic premise—because it ignores other equally valid reasons why people may purchase life insurance—the method does allow one to estimate a theoretical maximum consistent with the idea that a person should never be worth more economically to beneficiaries dead than alive. This method may provide a more accurate starting point than simple rules of thumb, while still being relatively easy conceptually—if not computationally—to understand.

Human Life value

A person’s human life value depends on numerous factors including future income levels, taxes, education, training, promotions, and various normal decremental factors such as the possibility of illness, disability, periods of unemployment, and the like. However, one usually can compute reasonable estimates of the present value of future earnings using four key inputs or assumptions:

1. Current annual after-tax earnings (C)

2. The projected rate of growth of earnings (g)

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3. The future working lifetime (n)

4. An after-tax discount rate (r)

Given these four factors, one computes the present but the discount rate is only 3 percent, the present value of future earnings using the present value of an annuity formula, Equation 15-1, as follows:2

Equation 15-1

where , the growth-adjusted discount rate, and . If = , the present value isr g r g simply equal to × .n C

The formula assumes earnings are paid annually in the middle of the year, which is a reasonable approximation to monthly or other periodic payments throughout the year.

For example, assume: (1) a client’s after-tax income is currently $50,000 per year; (2) he estimates it will grow at an average annual rate of 5 percent; (3) he is age thirty-five and expects to work for thirty more years until age sixty-five; and (4) an appropriate after-tax discount rate is 6 percent. The present value of his future earnings is about $1,275,000, computed as follows:

PV Future Earnings

The value of $1,275,000 is the amount that, if invested today at a 6 percent after-tax rate of return, could provide an after-tax income stream payable in the middle of each year for the next thirty years, with the initial after-tax amount starting at $50,000 and each subsequent payment growing by 5 percent. After thirty years, the entire $1,275,000 would be used up.

Basic Assumptions

The present value of future earnings is very sensitive to changes in the underlying earnings growth and discount rate assumptions. For example, if one assumes earnings will grow at 2 percent rather than 5 percent and the discount rate remains at 6 percent, the present value is $881,000, or almost one-third less. If instead, one assumes as before that earnings will grow at 5 percent, value is just over $1,980,000, or more than half again greater.

What are reasonable assumptions for the earnings growth and discount rates?

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Earnings Growth Rate

The earnings growth rate usually will depend on inflation rates and tax rates, as well as career opportunities. As a guideline, keep in mind that the average annual compound U.S. growth rate of inflation-adjusted disposable (after-tax) income has been just over 2 percent over the long run. In other words, on average, after-tax incomes have increased by about 2 percent more than inflation each year. Year to year, the rate has varied widely, but for estimation purposes, long-term trends are most appropriate.

Inflation itself has averaged slightly more than 4 percent per year over the period 1977 to 2006, but it too varies widely from year to year or from subperiod to subperiod. For the period from 1977 to 1986, inflation averaged 10.68 percent per year. This is considerably higher than the 3.65 percent average for the period from 1997 to 2006. The recent trend of inflation rates has been down. However, there have been long periods where inflation rates remain quite high.

The 2 percent U.S. average growth in inflation-adjusted disposable earnings is an average across all industries and occupations and all age groups. But it is not necessarily a good estimate of real average annual earnings growth for any particular individual. First, every individual is unique and may advance faster or slower than others within his or her occupation. Second, earnings growth rates vary among industries and occupations. Some occupations or occupations within certain industries experience greater than average earnings increases as computed across all occupations while other occupations are experiencing less than average increases. So estimates of earnings growth rates must3

take close account of the particular talents and potential of the client and the character of the lifetime earnings profile of his or her chosen occupation.

As a practical matter, estimates of future real inflation-adjusted earnings growth rates are unnecessary in many cases. Many family breadwinners desire to provide a standard of living comparable to that the family currently enjoys if they should die. However, they do not feel quite the same responsibility to insure the increasing standard of living the family might enjoy while they live. If the objective is to maintain the family’s current standard of living, it is only necessary to estimate future inflation rates, not also earnings growth rates in excess of inflation. In these cases, an estimate of the average future inflation rate would be substituted for the earnings growth rate in Equation 15-1. The value so calculated is the amount that if invested today at the assumed after-tax rate of return could replace the wage earner’s current level of real inflation-adjusted after-tax income each year for the rest of what would be the wage earner’s remaining working lifetime.

After-tax Discount Rates

Estimating reasonable after-tax discount rates can be just as problematic. The basic question is: At what after-tax rate of return could the life insurance proceeds be invested over the long run? That depends on the risk one is willing to assume, tax rates, and inflation rates. As a guideline, presents average nominal and realFigure 15.2 (inflation-adjusted) compound returns for principal categories of marketable assets and inflation for the World War II period 1946 to 2011.

Using the post-World War II period 1946 to 2011 as a basis for estimating returns, an investment in long-term high-quality corporate bonds could be expected to return about

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10.59 percent before tax compounded annually. A fifty-fifty mix of high quality corporate bonds and common stocks—which is about as aggressive as one would want to assume the assets would be invested—could be expected to return about 8.30 percent. As Figure

shows, the real annual inflation-adjusted compound return for corporate bonds over15.2 this period was just 2.03 percent after adjusting for inflation (which averaged 3.89 percent); for a fifty-fifty bond/stock mix, about 4.24 percent. Chances are that returns for all asset classes will tend toward the long run average over time, but there is no assurance of when or even if that will actually happen.

Because the present values one computes will vary substantially depending on the assumed rate of return, it is best to discuss alternative assumptions with clients and let them be the guide—within informed reason—on selecting the appropriate discount rate. Because present values vary inversely with the assumed discount rate, the conservative and prudent practice is to err on the side of lower, rather than higher, assumed rates.

To determine the appropriate discount rate, one must adjust whatever estimate of return one starts with for taxes. The tendency is to overstate tax rates because appropriate adjustments for standard deductions and personal exemptions, as well as the tax-free recovery of investment, are neglected. The effect of the standard deduction and personal exemptions may be to reduce the appropriate tax rate for use in equation 15-1 to about 20 percent to 80 percent of the marginal tax bracket rate for a comparable level of adjusted gross income. The effect of the exclusion of amounts treated as a recovery of the initial investment may further reduce the effective average tax rate by one-third or more. In general, it is suitable to apply tax rates ranging from about 4 percent to about 10 percent when determining after-tax discount rates to use in equation 15-1.

Family Support Ratio

Under the income replacement approach, insurance value is always less than human life value. The portion of after-tax income spent for self-maintenance is not available for the family, so only the remaining portion is what is devoted to or spent in support of the family. Advisers often assume that breadwinners spend about 25 percent of after-tax income for self-maintenance and the remaining 75 percent for family support. However, this ratio may vary widely from family to family. In general, the proportion spent in support of the family is somewhat less at higher incomes than at lower incomes and is higher the greater is the number of children. In addition, under the basic premise of this method, one of the important elements of family support is the cost of the insurance itself. Because the amount spent for insurance is not otherwise available to support the family’s standard of living, this cost should further reduce the proportion of income that is insured to support the surviving family members’ standard of living.

Figure 15.2

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Therefore, once one estimates the breadwinner’s human life value, one should multiply that amount by the family support ratio. For example, if the calculations determine that the present value of future earnings is $1 million and one also assumes that the family needs 70 percent of the breadwinner’s after-tax income to support the surviving family members’ standard of living, then the amount needed to maintain the family in the event of the breadwinner’s death is $700,000.

Other Adjustments

The amount so determined is not necessarily the amount of additional insurance required. Planners should further reduce this amount by the amount of any assets that are currently available to fund the survivor’s income needs and by any life insurance currently in force. Among the assets that planners should count are marketable securities, savings account balances, and the like, as well as current vested account or benefit balances in employer-sponsored pension and profit-sharing plans, Internal Revenue Code section 403(a) or (b) tax-deferred annuity plans, Individual Retirement Arrangements (IRAs) and Roth IRAs, Simplified Employee Pensions (SEPs), Keogh plans, and SIMPLE IRAs.

Many advisers feel that the family should also increase the support ratio to account for contributions or credits that the breadwinner would make to employer-sponsored retirement plans (qualified and nonqualified) while the breadwinner lives. For example, assume the employer sponsors a 401(k) plan that will match 50 percent of employee contributions up to 6 percent of pay. If the employee has 6 percent of pay deducted for the 401(k), the reported after-tax salary is reduced by about 6 percent. However, the 401(k) plan increases by 9 percent of pay. Assuming, for simplicity, that the employee is in the 33 percent tax bracket, this is effectively equivalent to an offsetting 6 percent increase in the employee’s after-tax income. Therefore, planners should compute the family support ratio based upon the reported after-tax income increased by the effective after-tax value of the 401(k) contributions. If one otherwise assumes the family support ratio is 70 percent, one should increase it to 74.2 percent to account for the equivalent after-tax value of the employer-sponsored plan (70% × 6% = 4.2%).

In addition, many advisers strongly suggest that the family should increase the amount by any outstanding debts, such as personal loans and the home mortgage, and by anticipated final death expenses. Although it violates the general premise of the income replacement method (which is to provide a fund sufficient, but no larger than that necessary, to replace what the breadwinner would provide to the family if and while he or she lives), in some cases advisers further recommend that family breadwinners acquire additional insurance to fund special objectives, such as college education funds for the

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children. In general, many families consider such funding objectives part of their normal support obligation and implicitly include such objectives when selecting the family support ratio.

Adjustment for Social Security Survivor Benefits

Most workers are covered by Social Security or some other government program that provides survivor benefits to surviving spouses with dependent children and surviving spouses alone after age sixty. This is a form of income-replacement insurance and should reduce the present value of the family support obligation accordingly. The amount paid to a surviving spouse with at least one eligible child (under age sixteen or disabled before age twenty-two) is 75 percent of the deceased spouse’s Primary Insurance Amount (PIA) at the date of death. For each eligible child, an additional 75 percent of the PIA is payable. Children are eligible for a child’s benefit until age eighteen, or until age nineteen if in high school, or as long as they are disabled if disability occurs before age twenty-two. A spouse alone is eligible for reduced benefits equal to 71.5 percent of the PIA starting at age sixty, or if receipt of benefits is delayed, up to 100 percent of the PIA starting at normal retirement age. A disabled spouse is eligible for 71.5 percent of the PIA starting at age fifty. The total4

amount payable to the family is subject to a limit, called the maximum family benefit, which can range from 150 percent to about 187.5 percent of the PIA.

The PIA depends on both the level of pay and the number of years in covered employment. An annual Social Security Statement is sent to most participants within three months of their birthdays. This statement provides information regarding a person’s current insurance status in the Social Security program, earnings history, current PIA, and estimates of benefits. Any participant who does not receive the automatic Statement by one month before her month of birth or who needs a Statement sooner than she is scheduled to receive it may request a statement at any time. A person may process the request online5

or by mailing Form SSA-7004-PC to the Social Security Administration.6

can be used to estimate survivor benefits. The figures are for 2012 and areFigure 15.3 based on the assumption that the worker has been employed steadily and received 5 percent pay raises throughout his or her working career. In the case of the $110,100 wages, wages are assumed to be equal to or greater than the maximum OASDI wage base for all years. Normal retirement age depends on when a person was born. Like other Social Security benefits, survivor benefits are increased each year to reflect changes in the cost of living. Therefore, readers may use the table to estimate benefits in 2012 and later years by scaling the appropriate figures up by the rate of increase in the CPI since 2012.

. Mike Fox, is married and is currently earning $60,000 in FICA wages,Example is age forty-five (wife, Mary, age forty-five), and has two children, ages nine and five. According to , Mary and each of Mike’s two children are eligible forFigure 15.2 survivor benefits of $1,304 a month, or $3,912 total in 2012 dollars. However, the maximum monthly family benefit is $3,088 in 2012 dollars. The annual benefit of $37,056 (12 × $3,088) would be payable for nine years until Mike’s nine-year-old turns age eighteen (or nineteen if the child is still in high school). (All benefits would be increased each year for inflation.) After that, $31,296 (12 × $1,304 × 2: the maximum family benefit limit is higher at this point and no longer applies) would be payable for two years until Mike’s second child reaches age sixteen. At this point,

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Mary’s benefit payments would cease until she reaches age sixty. Mike’s second child would continue to receive a child’s benefit of $15,648 (12 × $1,304 × 1) for two more years until age eighteen (or nineteen if a full time high school student).

When Mary reaches age sixty, she will be eligible for $1,244 per month (in 2012 dollars) for life, or if she waits until age sixty-seven (her normal retirement age) to begin receiving payments, $1,739 (in 2012 dollars). Of course, Mary’s benefits must also be adjusted for anticipated increases due to inflation until benefits begin. The mechanics of this adjustment are explained in the following section.

Converting Social Security Survivor Benefits to Present values

To account for these Social Security benefits when determining the amount of insurance required, one must convert the Social Security benefits into a present value using Equation 15-1. Using the prior example to demonstrate the procedure, the benefits payable during the children’s eligibility period are best viewed in three components:7

1. a stream of $15,648 (12 × $1,304 in 2012 dollars) annual payments for thirteen years (the youngest child’s benefit until reaching age eighteen); and

2. a stream of $15,648 (12 × $1,304 in 2012 dollars) payable for eleven years (Mary’s benefit until the youngest child reaches age sixteen); and

3. a stream of $5,760 ($37,056 Maximum Family Benefit - $31,296 [$15,648 × 2: Mary’s and youngest child’s benefits] in 2012 dollars) payable for nine years (the incremental benefit payable to the oldest child as limited by the maximum family benefit).

Assuming benefits continue to inflate at a 3 percent rate each year and that 6 percent is a reasonable interest rate assumption, Equation 15-1 would be used to determine the present values as follows:

PV Benefit Stream 1

Figure 15.3

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PV Benefit Stream 2

PV Benefit Stream 3

PV Streams (1) + (2) + (3)

The present value of Social Security benefits payable to the spouse, Mary in this case, is determined in a similar manner, except that the present value must be adjusted for the fact benefits will not be paid until Mary reaches at least age sixty. This can be accomplished in8

several ways, but the easiest method is to use a two-step procedure where one first calculates the present value as if the payments were to begin today and then discounts this value at the assumed inflation-adjusted rate of return for the number of years until payments would actually begin. The formula for finding the present value of a future lump sum value of the spouse’s benefits is:

Equation 15-2

Present Value of Future Lump Sum(FLS)

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where i is computed using the assumed before-tax discount rate. The before-tax discount rate is used because Social Security benefits generally are paid free of income tax.9

Equation 15-1 can be used in the first-step calculation to determine the lump sum value of the benefit stream payable to Mary, assuming that Mary were currently age sixty (or at normal retirement age, depending on which age benefits are assumed to start). The term of the payment period should be Mary’s life expectancy at the age payments are assumed to begin. Based on IRS Table V (see ), life expectancy for a sixty-year-old is 24.2Figure 15.4 10

years. Of course, adjustments should probably be made for any known health problems, the family history of longevity, and the fact that females still tend to live longer than males, although the gap is narrowing slightly. Assuming payments will begin at Mary’s age sixty,11

her monthly payments will be $1,244, or $14,928 annually. If the appropriate life expectancy is 24.2 years, the discount rate is 6 percent, and the inflation rate is 3 percent (that is, i = 0.02913), the future lump sum value of Mary’s benefit stream when she is age sixty using 2012 dollars is:

Future Lump Sum Value Spouse s Benefit Age 60

Future Lump Sum Value Spouse’s Benefit Age 60 = $14,928 × 17.19404 × 0.999155 = $256,456

Equation 15-2 is now applied to complete the second step of the calculation. In this case, Mary is currently age forty-five, so the future Social Security benefits will begin in fifteen years at age sixty. The present value of the future lump sum value of Mary’s benefits is computed as follows:

Present Value of Future Lump Sum (FLS)

The present values of all Social Security benefits to the family are summed to determine the current insurance value of the Social Security benefits. In this case, the present value of the Social Security benefits payable to Mary and the children while the children are young is approximately $360,000, and payable to Mary upon reaching age sixty is approximately $167,000, for a total of about $527,000. The present value of the family support obligation otherwise determined should then be reduced by this amount in deriving the required amount of insurance.

Income Replacement Approach – Step by Step

presents a work sheet that summarizes the nine basic steps in using theFigure 15.5

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income replacement approach to determine insurance need.

For example, in the case of the Mike Fox family, the analysis would proceed as follows. Assume Mike’s after-income-and-FICA tax take-home pay is $50,000. Assume also that Mike expects his income to grow at 4 percent (which is 1 percent more than the assumed rate of inflation of 3 percent, to be consistent with assumptions regarding Social Security benefits). Also assume, that a 2 percent after-tax return in excess of inflation is reasonable, or about 5 percent. In this case, then, the earnings-adjusted discount rate for computing the present value of Mike’s future earnings is about 1 percent (5 percent less 4 percent). Further assume Mike’s employer provides an insurance benefit equal to one and one-half times Mike’s gross pay of $60,000, or $90,000 and that he has $30,000 in marketable assets and cash available to help fund the family’s income need. Assume further that Mike’s current mortgage balance is $110,000, which he would like paid off in the event of his death and that final death expenses are expected to be about $15,000. Finally, assume about 75 percent of Mike’s after-tax income would be necessary to support the family’s current standard of living should he die.

Figure 15.4

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Figure 15.5

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Based on these assumptions and using Equation 15-1, the present value of Mike’s twenty years of future after-tax earnings is about $892,186, which is entered in Step 1 of the work sheet (see ). Multiplying this present value by the 75 percent familyFigure 15.6 support ratio determines the present value of the family support obligation, which is $669,140. As described above, the present value of the survivorship benefits under Social Security is $527,000. This amount, together with the $90,000 of employer-provided life insurance and $30,000 of available assets, reduces the present value of the family support obligation by $647,000 to just $22,140. When the special funding needs totaling $125,000 are added, the amount of insurance required is determined to be about $147,140. This amount represents just about 2.5 times Mike’s current gross income of $60,000.

NEEDS ANALYSIS

In contrast with the income replacement approach, which is founded on the premise that the insurance need should be based on the income that would be lost if the insured dies, the needs approach estimates the insured’s family income needs directly. The typical needs of a family can be divided into two categories.

The first category of needs consists of lump sum cash needs at death, typically including:

• administrative/final expenses;

• estate settlement costs;

• debt liquidation;

• tax liabilities;

• an education fund;

• an emergency fund; and

• any other special funding needs.

Figure 15.6

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The second category of needs consists of multi-period income needs and is comprised of:

• an adjustment period income;

• the surviving spouse’s income needs;

• the children’s income needs; and

• the spouse’s retirement needs.

Four common special needs and the types of policies used to fund those needs are as follows:

• – Here, all that is needed is the current amount at riskMortgage-repayment policy and how long that risk or need will need to be covered.

• – These could be for cars or any other type ofOther major-debt-repayment policies nonmortgage long-term debt.

• – This would be a policy to pay projectedEducation-fund-accumulation policy education costs for family members, if death occurred prematurely.

• – On estates below $5,450,000 (in 2016, with livingEstate-tax-liability policy spouse: $10,900,000) there would be little or no estate tax liability. Above these amounts, an estate tax may be due. The purchase of life insurance could obviate the necessity of the surviving spouse selling off assets to pay estate taxes.

The income needs are met from various sources including Social Security (survivor’s income), spouse’s earnings, annuity payments, employer-provided pension survivor benefits, and investment income. The excess of income needs over the expected income from these sources must be covered by income from reinvesting a lump sum life insurance death benefit or by taking an annuity settlement from the insurance company.

The lump sum required to generate a predetermined monthly income depends on whether or not the capital will be depleted or preserved. Essentially, the decision to preserve some or all of the capital can be viewed as a third category of need or objective –

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the desire to leave something to heirs, or perhaps to a favorite charity, after the surviving spouse dies.

As a practical matter, the capital necessary to fund the spouse’s income needs is often calculated in two ways that provide an upper and lower boundary on the required capital. First, the more conservative approach is to plan to preserve capital. The required capital is then the amount that is sufficient to pay the required cash income from interest on the capital alone. This approach assures income to the surviving spouse regardless of how long the spouse may live and provides an extra margin of security. However, the cost of insurance may exceed the amount that the insured feels is affordable. The second approach is to assume that both income and capital will provide the required cash income and capital will be entirely consumed over a specified period. In general, the payout period is set equal to or slightly greater than the spouse’s remaining life expectancy. If the spouse’s remaining life expectancy is long and the assumed interest rate sufficiently high, the difference between the amount necessary if capital is preserved and the amount necessary if capital is depleted is relatively small.

Insurance Needs Analysis Work Sheet

The “Insurance Needs Analysis Work Sheet” shown in summarizes theFigure 15.7 steps in applying this approach. First, current cash needs are estimated and totaled. Then the capital necessary to fund the lifetime income needs of the spouse and children is estimated. Finally, the total value of assets currently available is subtracted from the sum of the current cash needs and the capital necessary to fund the income needs to determine the current surplus or deficit. Additional insurance is required if there is a deficit.

The work sheet calculates the capital necessary to fund the spouse’s income needs, both if capital is preserved and if it is consumed over a period equal to or greater than the spouse’s remaining life expectancy. Given the prevalence of two-income families, the capital necessary to fund the spouse’s income needs should be reduced by the present value of her estimated lifetime earnings, if any.

The interest rate assumption is critical. As discussed earlier in regard to the income replacement approach, the assumed interest rate should be an after-tax interest rate. Also, if the objective is to maintain the family’s real inflation-adjusted standard of living, the assumed interest rate should be an inflation-adjusted after-tax interest rate. For example, if inflation is expected to average 4 percent per year and the after-tax rate of return is expected to average 7 percent per year, about a 3 percent interest rate should be used in the work sheet to estimate the required capital.

Because the income needs of the children usually terminate when they leave the home, typically after they complete school, begin their own careers, and start their own families, the capital necessary to fund their income needs is computed assuming that it is depleted, rather than preserved. The children’s Social Security benefits may be accounted for either by reducing their required monthly income on the work sheet by their estimated monthly Social Security survivor benefits or by including the present value of their benefits in the section of the work sheet listing the capital assets that are currently available. If there is an objective to provide children with a nest egg or hope chest to start their independent careers, the present value of the desired amount may be included in the current cash needs. Alternatively, the number of years of income funding may be extended beyond the time when the children would normally be expected to leave the home. The work sheet

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aggregates the income needs of all children into one calculation, but it can be modified to calculate the capital required for each child separately.

Most insurance advisers also recommend funding for an adjustment period income for one to two years. The adjustment period income helps to defray costs that continue until the family is able to adjust to its new situation. For example, the family may be locked into certain obligations of the insured, such as car leases, rents, or health club memberships, which may not terminate until sometime after the insured’s death. Also, the confusion and disorientation that often follows the death of a loved one frequently may affect the family’s ability to manage its financial affairs. The adjustment income provides an extra income cushion until they can adapt.

Insurance Needs Analysis Case Study

shows the work sheet filled out for the Sam Sample family. If Sam were toFigure 15.8 die today, it is estimated that final expenses would be $20,000, $100,000 would be required to pay off the mortgage, and $24,000 would be required to pay off other debts and taxes ($10,000 + $4,000 + $10,000). It is also assumed, based on the current cost for a private college, that $75,000 would be required today to fund Sam’s twelve-year-old son’s college education starting in six years. Finally, Sam would also like to set up an emergency fund of $25,000 in the event he dies. Therefore, a total cash need in the event of Sam’s death is $244,000.

Based on his family’s current lifestyle, Sam estimates that his wife would need $3,500 per month after tax in current dollars to maintain her standard of living if Sam died. Assuming available assets could be invested at an average annual after-tax return (6 percent) that is 3 percent greater than inflation (3 percent), the capital required to provide this level of real inflation-adjusted income indefinitely (that is, by preserving the real purchasing power of the capital) is about $1,403,500. Sam’s wife, who is age forty, has a life expectancy of 42.5 years, according to Table V. The capital required to provide Sam’s wife with an inflation-adjusted after-tax monthly income equivalent to $3,500 in current dollars for forty-five years is less, at about $1,029,000.

Sam’s wife works and earns about $1,200 per month after-tax. Assuming that she would continue to work until age sixty-five (for twenty-five years) and her earnings would increase at the rate of inflation, the present value of her income stream is about $250,650. This amount reduces the amount of capital required to fund Sam’s wife’s income needs. The amount of income currently required to maintain Sam’s son’s standard of living is about $1,000 per month. Sam wants to provide for his son until he graduates from college, which should occur in twelve years. The capital required to fund this need, once again adjusted for inflation, is about $119,400.

Finally, Sam would like to provide an additional income of about $1,000 per month (adjusted for inflation) for two years to help the family through the adjustment period in the event he dies. He needs about $23,000 to provide this income.

The total capital required to fund the family’s income needs is about $1,295,000 if the capital required to fund Sam’s wife’s income is to be preserved, or $921,000, if it is to be depleted over forty-five years. The difference, $374,000, is significant. The difference in the

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two approaches is especially striking if it is couched in future value terms. If the capital is liquidated, in forty-five years no capital will remain. If the capital is preserved, and inflation averages 3 percent per year, in forty-five years the capital value will exceed $5.3 million.12

The assets available to fund the current cash and income needs total $600,000. Therefore, the insurance need is somewhere between $565,000 and $940,000 depending on whether or not the capital required to fund Sam’s wife’s income needs is preserved or liquidated. By selecting an intermediate amount, Sam can assure adequate income at least until his wife reaches age eighty-five with a reserve in case she lives longer or an inheritance for Sam’s son if she does not survive beyond age eighty-five. The choice will usually depend on the insured’s overall objectives and ability to pay insurance premiums.

STATIC VERSUS DYNAMIC ANALYSIS

Each of the approaches discussed above is a static analysis that bases the estimate of the required insurance on the needs that must be funded if the insured were to die immediately. But in most cases, the insured will not die immediately. A dynamic analysis looks at how the insurance need is expected to change over time based on current expectations if the insured lives. How the insurance need is expected to change over time may have a strong effect on the most appropriate insurance plan and the selection of the most suitable policies.

The first impression is usually that the insurance need should decline as the insured ages, since the period of the family’s income need should be shorter. However, first impressions can be mistaken. For example, shows an analysis of Sam’sFigure 15.9 insurance need in six years. All of the cash needs are assumed to grow at about the rate of inflation, 3 percent, except the mortgage fund, notes payable, the education expenses, and the taxes payable. The mortgage is assumed to be paid down from $100,000 to $80,000. The notes payable are assumed to remain the same. The taxes payable are assumed to have been entirely repaid. The education fund that is necessary to fund college expenses immediately is estimated to be $120,000, not $75,000, since it must be increased both for inflation plus the interest that was implicitly assumed would be earned on the education fund had Sam died six years earlier. Therefore, current cash needs increase by $31,670, from $244,000 to $275,670.

The income needs for Sam’s wife and son and the adjustment period income are each increased by the assumed 3 percent rate of inflation from $3,500, $1,000, and $1,000, to $4,179, $1,194, and $1,194, respectively. Similarly, Sam’s wife’s wages are also expected to increase with the rate of inflation from $1,200 to $1,433. In six years, at age forty-six, Sam’s wife’s life expectancy will be 36.8 years (from Table V). Adding the 2.5 year margin that was included in the original analysis, the liquidation period is down from forty-five years to 38.3 years. Also, Sam’s wife’s remaining working career is reduced by six years from twenty-five years to nineteen years. Similarly, the income payout period for Sam’s son is reduced by six years from twelve years to six years.

Finally, all of the capital assets available to fund the family’s needs are assumed to grow by about 10 percent except the insurance amount and the Social Security benefits. The life insurance is the same on the assumption that Sam had not purchased additional insurance six years earlier. The Social Security benefits are $60,000, or $40,000 less, since the period when Sam’s son would receive survivor benefits has been eliminated. The only

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amount remaining is the present value of Sam’s wife’s survivor benefit which will not be payable for another nineteen years. Therefore, the total assets available to fund the family’s needs increases by $191,600, from $600,000 to $791,600.

Based on these quite reasonable assumptions, the required insurance has increased by about $80,000, from approximately $939,000 to $1,019,000, if the objective is to fund Sam’s wife’s income needs without liquidating capital. However, if the capital liquidation approach is used, the insurance need declines slightly, from approximately $565,000 to about $475,000, or by about $90,000.

As this example demonstrates, it is important to look beyond an immediate snapshot of the insurance need to future needs based upon reasonable assumptions. Beyond this, it is critical to periodically update and review insurance plans, since the future virtually never unfolds exactly as projected. The greater the uncertainty of future events, the more important it is to build flexibility into the insurance plan to handle all eventualities.

BUSINESS INSURANCE NEEDS ANALYSIS

Life insurance is used in business applications to insure key employees, fund buy-sell agreements, and in various compensation arrangements, such as in death-benefit only plans, Section 162 plans, split dollar arrangements, and in qualified pension and nonqualified deferred compensation plans. The insurance need in most of these cases depends on circumstances peculiar to each case, and is beyond the scope of the current discussion. However, the insurance need in most key employee situations is amenable to a systematic and generic type of analysis, which is presented in the following paragraphs.

Key Employee Insurance

In most businesses, especially in smaller firms, one or a few key employees are responsible for a significant portion of the firm’s earning capacity. The premature death or disability, or an untimely resignation, of these employees can have a severe impact on the firm’s profitability, and may even cause the firm to fail. Noncompete clauses in employment/severance agreements, cross-training among key employees, and a management philosophy and practice of mentoring subordinates, along with attractive and properly-designed compensation packages, can help to prevent or minimize the risk of early resignation. Life and disability insurance on key employees is the logical choice to help the firm weather the financial loss of a premature death or serious disability. But the critical question remains – how do you determine the insurable value of the key employee to the firm?

A commonly held maxim of management is that no one is irreplaceable. That is generally true, but it does not mean that replacement is costless and that full value can always be recouped. In any event, the loss of a key employee will generally cause business and management disruptions and will entail a period of adjustment before a new replacement is up to speed and the company can adapt to the new arrangements. A properly designed insurance plan can provide the funds necessary to finance the transition period. Since most companies, and especially smaller firms, do not have unlimited cash resources for insurance premiums, it is critical to have enough, but not too much insurance.

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Critique of Ad Hoc Rules of Thumb and Common Key Employee valuation Approaches

Various ad hoc rules of thumb and approaches have been used to estimate the value of a key employee. These rules, although simple to apply, are conceptually limited. For example, estimating an employee’s value as some multiple of salary is entirely arbitrary. What multiple is appropriate? In addition, it takes no account of the timing of cash losses. The effect, in many cases, may not actually appear in revenues until future periods.

Alternatively, a key employee’s value is sometimes estimated by capitalizing the corporate earnings attributable to the employee’s efforts, skills, knowledge, talents, contacts, sales results, or other attributes. A similar approach is to estimate the percentage reduction in the firm’s going concern value that would result from loss of the key employee and to multiply that percentage by the firm’s going concern value. One problem with these approaches is that they implicitly or explicitly require a valuation of the firm in order to value key employees. Although key employees are an important component contributing to a firm’s value, the relationship is not often clear or direct. And although up-to-date and continuous knowledge of a firm’s going-concern value would always be welcome for a host of reasons, it is usually neither easy nor inexpensive to perform such valuations, especially in small closely held businesses.

Figure 15.7

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Figure 15.8

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Figure 15.9

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A second and more basic problem with these approaches is that they implicitly assume the key employee is irreplaceable, and his or her loss is a dead weight and irrecoverable loss to the firm. These approaches tend to overestimate the loss to the firm. In virtually all cases, if there is adequate liquidity to cover the transition period, a replacement can ultimately be found who can fulfill many, if not all, of the functions of the lost key employee and the company’s management practices can be adapted over time to compensate for the loss.

Basic Principles of Key Employee valuation

A conceptually sound approach to key employee valuation should:

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• measure the financial loss based on what the employee would have contributed to the future success of the firm;

• adjust the financial consequences for the timing of those lost contributions;

• account for trends in the employee’s contributions;

• realize that, in every case, a key employee’s contribution to the firm will terminate at some point, either through death, disability, resignation, or retirement; and

• recognize that most, if not all, of the value of the key employee’s contribution to the firm can and will be recovered over time, either by hiring and training a replacement, adapting or changing the management practices and functions of other key employees, or some combination.

Although an employee’s past contributions are often a major component in determining the employee’s present compensation, the cost to the firm of the employee’s loss depends on the – on what the employee could be expected to contribute in subsequent years.future In this regard, both the timing and trend of these future contributions are critical. The loss of an employee who is essential to the successful close of a major deal is much more costly if the deal is expected to close within the next few months than if it is not expected to close for a year or two. Similarly, the trend is important. It is much more costly to lose a relatively new “rainmaker,” who is still in the process of bringing new accounts within the firm, than to lose the same employee later, after many of those accounts have been acquired and become accustomed to and comfortable with the firm.

One mistake frequently encountered in key employee valuations is the failure to account for the fact that every key employee, sooner or later, for one reason or another, will

employment with the firm. It is not a question of if the key employee is lost, butterminate when. This is a simple fact of life that every firm must face. And while it is true that without proper planning the loss of a key employee could, in some circumstances, sound the death knell for a firm, it is usually entirely avoidable. If a firm can anticipate and survive a key employee’s retirement, it should also be able to plan for and survive the loss as a result of death, disability, or resignation.

Any valuation based on the presumption of a permanent and irrecoverable loss will usually be invalid and overstated. The impact of the loss of a key employee’s contributions to the firm will virtually always diminish over time as the firm adjusts its practices and reallocates or replaces lost resources. And although a replacement may not be able to exactly replicate the contributions of the lost employee, over time much of the lost contributions can be recovered through training and experience. In addition, the replacement will frequently bring her own unique talents to the job, adding dimensions that the key employee may have lacked. Therefore, ultimately no permanent or ongoing loss to the firm should result.13

Key Employee valuation Method

presents a key employee valuation work sheet that incorporates theFigure 15.10 principal elements of a complete and systematic method of valuation. The method14

estimates the difference between the key employee’s and a replacement employee’s contributions to the firm each year over a transition training period. The present value of the

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differences is an estimate of the amount of insurance required to carry the firm through the transition period.

The following factors are required inputs:

1. The number of years that would be necessary to locate, hire, train, and develop a replacement for the key employee until the replacement could be expected to match the contributions expected from the key employee. In general, this would be expected to take five years or less, but the worksheet could be expanded beyond five years, if necessary.

2. The firm’s estimated gross revenues for each year of the transition period assuming the key employee were still with the firm (line 1).

3. An estimate of the percentage of gross revenues attributable to activities of the key employee (line 2). This percentage may be assumed to be equal each year, or it may be varied, depending on the firm’s development plans and the key employee’s role in those developments.

4. The expected total compensation to the key employee each year over the transition period (line 4). This may be determined as a percentage of revenues or sales, as might often be the case with a key salesperson, or as some anticipated combination of salary and bonus, as might often be the case with key executives. This amount should include all compensation, including various employee benefits, such as medical benefits and pension contributions, as well as Social Security payments.

5. The total direct (and indirect) costs of locating, recruiting, hiring, installing, compensating, and training a replacement for each year of the transition period (line 8). Direct costs, especially in the first year, would include payments for the services of a professional recruiter; advertising; reimbursement of travel, meals, lodging, and local transportation expenses for replacement candidates; moving expenses and the like for the new hire; office outfitting and other possible expenses, such as the cost for a salesperson’s automobile; and the similar costs of recruitment for necessary new support positions, such as an administrative assistant to the replacement key employee; as well as the legal fees often associated with negotiating employment contracts with high-level executives and top salespersons.

Indirect costs that should not be overlooked are the opportunity cost of management time spent in the recruitment effort as well as the additional burdens placed on remaining key employees and management, both to cover the lost key employee’s duties until the replacement employee can fully shoulder the burden and to help train or acclimate the new employee.

6. An estimate of the contribution the replacement employee could be expected to make each year to the revenues of the firm relative to the contributions projected for the key employee as a percentage (line 6). Virtually nobody can be expected to step in and immediately match the performance of a true key employee. (If it were easy, the employee would not be considered a key or vital contributor to the firm’s success.) The transition period generally depends on the qualifications and experience of the specific person hired, which is difficult to estimate before the fact.

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However, there is usually a tradeoff between the time it takes for the replacement employee to develop her full contributory potential and the initial compensation level of the replacement employee. Trying to attract a person who is extremely well qualified and a better immediate match for the key employee will usually require a premium compensation package and may take more search time, sometimes a year or longer for specialized positions. Thus, it may be more an issue of management preference, than total cost, which route is taken to replace the key employee. If management plans to go the premium replacement route, higher compensation levels (generally even higher than that paid to the key employee) and recruitment expenses should be entered in line 8. Also, correspondingly higher relative performance percentages should be entered in line 6, but perhaps deferred for a year or so to reflect the longer expected time to find the premium replacement. The work sheet can be used to help evaluate the relative benefit or cost of each replacement strategy.

7. The discount rate for calculating present values (bottom of the worksheet). The discount rate should reflect the firm’s cost of capital or borrowing rate. The rate should be adjusted for the firm’s tax rate. Although death benefits will (usually ) be15

tax free, the returns on investment will be subject to tax.

Figure 15.10

The rest of the work sheet operates as follows:

• Line 3 computes the total projected revenues attributable to the key employee.

• Line 5 shows the key employee’s net projected contribution to the firm based on the difference between the key employee’s compensation and contribution to the firm.

• The replacement employee’s contribution to the firm relative to the contribution of

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the current key employee is calculated in line 7.

• The replacement employee’s net contribution (plus or minus) is computed in line 9.

• Line 10 computes the difference between the net contribution of the current key employee and the replacement employee.

• The discount factors for computing present values should be entered in line 11.

• The formula for computing each year’s discount factor is shown at the bottom of the work sheet.

• Line 12 computes the present value of each year’s loss in net contribution.

Finally, line 13 shows the cumulative present value of the loss in net contributions to the firm each year. The value in the last year of the transition period is the present value of the total loss and represents the amount that should be insured.

illustrates the use of the key employee valuation method described here. InFigure 15.11 this case, the firm’s plans are such that the key employee’s relative contribution is expected to decline somewhat (as indicated by the percentages in line 2) as the firm moves into some new operations. However, as indicated in line 3, the key employee’s contribution is still expected to be substantial and growing. It is assumed the relative contribution of a replacement employee will start at only 50 percent of the key employee’s contribution, but grow to 100 percent in five years. Although the replacement employee’s compensation is expected to be less than the key employee’s, the first year expenses of recruitment and placement, together with compensation, are expected to exceed the key employee’s compensation. In subsequent years, the replacement employee’s compensation is expected to be less than the key employee’s, but the replacement employee’s net contribution will still remain lower than what the key employee would have contributed. Based on the projected figures, the insurable value of the key employee is about $482,000.

Figure 15.11

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The work sheet may be a useful tool in justifying the desired amount of key employee coverage and convincing the insurer that there is sufficient insurable interest to issue the policy. In addition, it may be helpful in supporting the accumulation of contingency funds in excess of what may otherwise be allowed under the excess accumulated earnings provisions if challenged by the IRS.16

ESTATE PRESERVATION AND LIQUIDITY NEEDS ANALYSIS

For large estates, planning to minimize estate taxes and to assure adequate liquidity to pay estate taxes that cannot be avoided is of paramount importance. Planning should consider a host of techniques, including lifetime gifts, optimal use of the marital deduction, various marital and family trust arrangements, and charitable gifts, as well as life insurance. Estate and gift tax planning is beyond the scope of this chapter, but see for aChapter 16 discussion of federal estate and gift tax issues and planning techniques.

CHAPTER ENDNOTES . The table was developed by the staff of First National Bank (Citibank).1

. The first part of equation 15-1 is the standard formula for the present value of an annuity with2 payments at the end of each period (year). The second part of the equation is an adjustment factor to move the payments to the middle of each period (year) rather than the end. The value can be computed easily using a financial calculator.

. National or industry occupational averages may be misleading when trying to estimate earnings3 growth for a particular occupation for another reason. In many occupations, especially in the professions and in executive or managerial positions, the normal lifetime profile of any average individual’s earnings growth may show greater real growth than the average increase for that occupation as a whole.

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. The amount a spouse will get is a percentage of the deceased’s basic Social Security benefit.4 The percentage depends on age and the type of benefit. Normal Retirement Age (NRA), the age at which full Social Security retirement benefits are generally available, had been sixty-five for many years. However, beginning with people born in 1938 or later, NRA gradually increases until it reaches sixty-seven for people born after 1962. The following chart shows the steps in which the NRA will increase. For more information on widow(er)s benefits, see http://www.ssa

..gov/pubs/10084.html

. .5 https://s044a90.ssa.gov/apps6z/isss/main.html

. One can download Form SSA-7004 at and file the completed6 www.ssa.gov/online/ssa-7004.pdf form by mailing it to:

Social Security Administration

Wilkes Barre Data Operations Center

P.O. Box 7004

Wilkes Barre, PA 18767-7004

An excellent and concise source of information on Social Security benefits is Social , The National Underwriter Company, published annually.Security & Medicare Facts

. Where the maximum family benefit applies, individual social security benefits are generally7 reduced proportionately. The three categories here are not shown proportionately in order to facilitate calculation of the present value of the total benefits.

. The question of whether a surviving spouse should begin taking Social Security benefits at age8 sixty or later depends on a number of factors. There is a trade-off. Although if payments are started at age sixty, they will be paid longer, the amount is reduced. In general, it is optimal for a normal healthy surviving spouse to begin taking benefits at age sixty, rather than delaying the start to normal retirement age, even though payments are lower, if the appropriate inflation-adjusted discount rate for those future payments is above 3 percent. If the discount rate is below 3 percent, the spouse will be better off waiting to take payments. For a comprehensive discussion of the factors involved in this decision, see “When to Take Early Social Security Benefits,” Robert J. Doyle, Jr., , Vol. XLIV,The Journal of the American Society of CLU & ChFC No. 1 (January, 1990), pp. 30-37.

. Up to 85 percent of Social Security benefits are taxable under current law if modified taxable9 income – defined basically as normal taxable income plus tax-exempt bond interest income plus 50 percent of Social Security income – exceeds $34,000 for single taxpayers or $44,000 for married taxpayers.

. Table V is the unisex annuity life expectancy table described in Treas. Reg. §1.72-9.10

. Based on Table 90CM, the IRS table used for valuing annuities, life estates, and remainders for11

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income, gift, and estate tax purposes, the unisex life expectancy at age 60 is 20.9 years. These values represent a more conservative estimate of life expectancy and, as a result, produce a smaller present value for surviving spouse Social Security benefits. The effect is to increase the amount of insurance needed, all else being equal.

. In order to provide a level real inflation-adjusted income from interest only, that is, a nominal12 income that increases at the rate of inflation, the capital value must increase each year by the rate of inflation. By using a 3 percent inflation-adjusted interest rate to compute the required capital, the work sheet implicitly assumes the capital value grows at the rate of inflation. If inflation averages 3 percent per year, the capital value will grow by 3 percent per year. At a 3 percent annual growth rate, a dollar invested today will increase 3.7816 times in 45 years (1.0345

= 3.7816). Therefore, after subtracting the first month’s interest, which is assumed to be paid in advance, the remaining $1,400,000 should grow to $5.3 million in 45 years. Of course, the required monthly income will also grow correspondingly to $13,236 ($3,500 × 3.7816), or to $158,827 per year.

If the after tax inflation-adjusted interest is assumed to be 3 percent and inflation is 3 percent, the after tax rate of return must be 6.09 percent [which is determined by solving for x in the equation for the inflation-adjusted interest rate: 0.03 = (x -0.03) ÷ (1.03)]. For example, if $100 is invested to earn an after tax rate of return of 6.09 percent, the total income and principal at the end of the year would be $106.09. If inflation is 3 percent, the real inflation-adjusted end-of-period value is $103 ($106.09 ÷ 1.03). Therefore, the real inflation-adjusted return is 3 percent. If the objective is to provide $3 of real income and inflation is 3 percent, $3.09 must be distributed at the end of the year ($3 × 1.03). After paying the $3.09, the remaining balance is $103. Since inflation is assumed to be 3 percent, the real inflation-adjusted value of the capital remains intact. In other words, since the capital value increases by the rate of inflation each year, the fund is able to distribute 3 percent in real terms each year indefinitely.

. In those relatively rare cases where the key employee is the firm, for all practical purposes, his13 or her death would constitute a permanent and irreplaceable loss. In these cases, insurable value could be determined using a human life value income replacement approach as described earlier in this chapter.

. This work sheet is adapted from one developed by Robert Crowe as presented in 14 The Financial , , (The American College, 1989).Services Professional’s Guide to the State of the Art Chapter 8

. Insurance proceeds may be subject to regular income tax if the policy was acquired in a15 transaction subject to the transfer for value rule, which should generally be avoided, if possible. Otherwise, life insurance proceeds will generally be received by the corporation tax free if it has a legitimate insurable interest in the insured. However, corporate-owned life insurance proceeds are an item of tax preference and may be subject to an effective maximum alternative minimum tax rate of 15 percent. See for further discussion of the tax issues with respect toChapter 16 corporate-owned life insurance in general and key employee insurance in particular.

. Suggested references for further information on the subject of key employee valuation include:16

Black, Jr. and Black III, “Insurable Interest and Key Man Life Insurance Benefits,” The CPA , August 1987, p. 46.Journal

Robert M. Crowe, Time and Money: Using the Time Value Analysis in Financial Planning (Dow Jones-Irwin, 1987).

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